If someone asked me, “What is one investing rule you would never break?“, I would immediately say “Margin of Safety” without flinching. In fact, it has almost become an instinct for me to claim a Margin of Safety for every single one of my investment ideas. Why is being cautious so important in investing?
Margin of Safety: The Concept
We’ll start with a simple example. In many countries, the railway/subway stations have a marked boundary passengers are expected to stay inside of as a train arrives in a station.
If someone did stand outside the boundary, nothing life-threatening will happen 9 times out of 10. But people don’t (Mostly), because the cost of that 1-time-out-of-10 materializing is too high. It is not wise to play with death over a few inches of marked territory.
Now, to be more thorough, consider for a moment that you are the Chief Quality Inspector for a renowned airline. One fine day, you are asked to inspect a highly engineered airplane—say, something like the one below.
A crew tags along with you, giving you notes on how much each part on the plane have been used. You come across an extremely critical component in the engine. You are informed that out of the average allowed life of 10,000 hours-in-flight, 7,000 hours have been used up for that particular component. One of the crew members inquire you when it should be likely replaced.
If you are like most people, you might answer ‘9,000 hours’, ‘9,500 hours’ or perhaps even ‘9,999 hours’. After all, the engineers who built such a critical part must have also been brilliant enough to calculate the perfect time before which it would need replacement. So, why make your company spend anything extra well before the limit is in sight?
However, if you are like me, or most sane Quality Control authorities, you would sound an alarm well below the required limit—maybe at 7,000 hours or 7,500 hours (So, in the case of the inspection, almost immediately—maybe even demand a replacement of the part before the next flight).
Regardless of how brilliant the engineers were in building that part and estimating its useful life, the undeniable truth is that humans err. A minor mistake in the construction of the part or the calculations could lead to the part wearing away well before its life—or at the least, that’s a likely scenario.
I’m not making this up. Margin of Safety is an untold rule applicable in every place ranging from Civil Engineering to Atomic Physics. We even use it in so many real-life, day-to-day situations unwittingly. And sure enough, it is also applicable to investing.
Margin of Safety in Investing
Benjamin Graham once said:
“The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves…”
When it comes to investing, ‘Margin of Safety’ simply means purchasing a stock or an asset only when it is available at a significant discount to your estimated intrinsic value. We do this because, either:
- The nature of estimations guarantee that we will be inaccurate to an extent.
- The nature of auction-driven markets to fluctuate wildly may punish us in the most unexpected of ways.
- The nature of an ever-connected and ever-changing modern world means that us being completely wrong is a possibility.
Now, let’s say you have some idea of how much you’d like to purchase a stock at throughout a 5-year period. But almost certainly, the market will fluctuate in and out of the value the entire time. You do nothing when the price fluctuates out of your expected purchase price. When the market drops the price significantly below the value, that’s when a Margin of Safety is created. That’s when you should even begin considering a purchase.
I hope that’s understandable. Notice how I didn’t mention what valuation method needs to be used, because it doesn’t matter. You will have to demand a significant Margin of Safety regardless of how you arrived an intrinsic value or what valuation method sounds logical to you.
But of course, now you may ask “How much is significant?” I’ll let another ace investor answer your question with a picturesque example.
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.”
Only the Paranoid Survive
I personally demand at least a 20% Margin of Safety on every single one of my investments, even if I have the utmost conviction. There were instances when I have waited in the sidelines for an excruciating amount of time for an investment to give up a 50% Margin of Safety before choosing to pick it up.
One of my most favorite quotes in this regard comes from the ex-CEO of Intel, Mr. Andrew Grove.
“Only the paranoid survive.“
Remember, investing is just like business. Only the paranoid survive.